lecture

Lecture I: Pension Institutions, History and Theoretical Rationales I. Overview Overview of the 4 lectures: A. Profession Professional al caveat: Not an expert in pension pension systems. systems. There are many people who know much more about this that I and have spent lifetimes lifetimes studying it. Have benefitted benefitted tremendously tremendously from summaries summaries of the huge literature by various authors, enabling a newcomer like myself to learn a lot, quickly. Challenge of the area: combine knowledge of 1) institutions, 2) politics, 3) economic theory, theory, 4) data, 5) economometrics to obtain an overall understanding of how pension policy affects behavior. Importance of area in the future: the large fraction fraction of GNP devoted devoted to pensions, the aging of society, society, and the huge potential costs of inefficiencies. This is an area where I definitely definitely think economists and econometricians can make make a contrib contributi ution. on. Rewards Rewards to doing doing so are very very high. high. My comp compara arativ tivee advant advantage age:: using dynamic dynamic programming programming models to analyze analyze individual responses to pension incentives. incentives. Necessary Necessary condition condition for economists to have much of a role in pension policy issues is first demonstrating that people respond rationally to these incentives, otherwise retirement behavior might be better left to sociologists and psychologists psychologists.. Going to argue in these lectures lectures that people are quite rational, rational, selfish optimizers optimizers who will take advantage of the system if it is to their advantage. Moral scruples to claiming DI, cheating the system, or working becuase one “ought” to work for character reasons may be operative, but effects are domina dominated ted by econom economic ic incent incentive ives. s. People“play the system system”” to make make themse themselve lvess as well well off off as possib possible, le, and there is good evidence that they know the ins and the outs of the system and the various pension rules extremely extremely well. This is opposed to the “paternalistic “paternalistic”” “irrational” “irrational” view that people are myopic, stupid, and retire primarily for non-economic reasons and that details of pension policy therefore has little little impact on behavior behavior.. Course Course will attempt to compare both points of view, especially especially since the paternalistic view is often quoted as one of the motivating reasons for the establishment of private pensions. B. Politi Political cal caveat: caveat: Issues Issues of retireme retirement, nt, disabi disabilit lity y, etc. etc. are highly highly politica politically lly charged. charged. Even in the economic economic literature literature one see’s highly value-laden value-laden terminology terminology e.g. “actuarial “actuarially ly fair/unfair”, fair/unfair”, “prema“premature/early retirement”, and potentially judgmental concepts such as pensions as device to rid the firm of  “unproductive older workers”, or individuals “feigning ill health” to obtain DI benefits or “rationalize” fact that they are not working. With With the potential that benefits benefits to elderly may have to be cut in many OECD countries, can expect huge political battles. In US AARP is a huge lobby with extreme amount

Also, Also, please lert me to language differencesin differencesin terminolog terminology. y. E.g. Social security security vs. public public pension, fully-funded fully-funded vs. capital capital reserve, private private pension vs. occuppational scheme or superannuation scheme, etc.

of political political power very sensitive to any suggestion suggestion of cutting benefits “owed” “owed” to America’s America’s old. So important to approach the issue with a certain amount of sensitivity. Also recent conservative doctrines have appeared appeared questioning questioning whether government government ought to be in the pension business: business: why not let the free market do it if as economists we believe in “free trade” and the superiority of market solutions to private solutions. Feldstein’s program program on privatisation of social security systems starting starting in Chile and elsewhere. My own position: political liberal who favors redistribution from rich to poor, insurance to unheal unhealthy thy or disabled, disabled, and concer concern n for the well-be well-being ing of our elderl elderly y and the recogn recogniti ition on and preser preservat vation ion of respect respect for their their independence independence and human dignity dignity.. Don’t Don’t believe believe that the privat privatee market can provide provide a total solution: indeed will be arguing that one of the most compelling ways to understand the origin and economic economic effects effects of public pension pension systems is due to the government government stepping stepping in to correct failures of  the private market, particularly particularly in annuities and health insurance and disability insurance markets where there are good economic reasons why private markets should be weak or non-existent. Fundamentally, I have in mind the same ideal of the tolerant, humane society that European social democracies have tried tried to attain. attain. But I am also a realist and realize realize that it is human nature to try to make oneself oneself as well off as possible, optimizing relative to the rules that are in force, in some cases even taking advantage of the benevolence benevolence of the government and society society. Without Without realism, realism, and a proper understanding understanding of  individuals’ strategic responses to public and private pension/DI/health insurance policies, (as opposed to the assumptio assumption n of perfectly perfectly moral moral behavior), behavior), the benevolent benevolent policies policies enacted enacted over the last last half century century are threatened. threatened. Need to design incentive incentive schemes schemes that are as “strategy proof” as possible in order to direct as much possible aid/insurance to those really in need, and also to preserve political consensus to continue these remarkable “social institutions”. II. Overview of Institutions A. Pensions are delayed compensation schemes ( often involving forced savings) that “tax” wage earnings when young in exchange for a stream of retirement retirement benefits when old. Pension Pension systems are widespread widespread in industrialized societies, offered to 1) employees of private firms, 2) public employees military, military, and 3) (virtually) all individuals via universal public pension schemes, also known as social security systems. B. Why do pension pensionss exist? exist? I will will review review more detail detailed ed reasons reasons later later,, but basic reason reason is to provid providee an adequate stream stream of consumption consumption in old age. Basic life-cyc life-cycle le model in figure 1 shows problem: problem: individuals work while young but for various reasons (age related declines in health productivity, and age-related changes in marginal utility of income/leisure) people’s earning capacity slows down at end of their their life life and they they withdr withdraw aw from from labor labor market market.. They want, want, howeve however, r, to maint maintain ain a reason reasonabl ably y smooth smooth level of consumption, so pensions provide one way to obtain a relatively smooth lifetime consumption stream, taxing wage earnings when young in exchange for wage earnings when old.

C. Why don’t individuals just save instead of using pensions? A major reason is that people have random lifespans: lifespans: expected expected lifespan lifespan for males may be 75 years, but they could live to age 99. Should one save for the worst case, assuming one will live to age 99? If so, accumulating sufficient savings will involve major sacrifices sacrifices early early in life, especially especially if it turns out that one dies early, early, say at age 55. ON the other hand if save only enough enough to live to 75, what happens if if live to 99? Will Will one be reduced to living living on handouts or on welfare? D. Why don’t individuals purchase annuities to insure against mortality risk? In practice, annuity markets are very thin or non-existent non-existent in most countries around around the world. When they do exist they are often very expensive expensive relative relative to the annuity payments payments one actually receives. receives. High “load” factors. factors. Why are they so expensive and so few exist? Reason 1): the classic adverse selection argument: there is a great deal of individual heterogeneity in health and longevity, which is private information to individuals. Insurance company only knows aggregate, average mortality rates. Individuals know whether there is a family history of cancer, heart heart attack, stoke, etc. If annuity is set on average mortali mortality ty rates, those who are “good “good risks” risks” from the insurance insurance company’s company’s standpoint standpoint (i.e. those who are likely likely to have cancer cancer,, heart attacks, attacks, strokes, etc. and die off early) early) are less likely likely to apply and those who come from strong, healthy Scandanavian backgrounds (the “clean livers” who don’t smoke, exercise, and may have at most 1 drink per day) are more likely to apply, forcing the insurance company to raise its premiums or reduce its benefits, causing still more good risks to leave, etc. In extreme circumstances this process of  adverse selection can completely drive the annuity market out of existence (see Rothschild and Stiglitz, 1976, QJE, “Equilibrium “Equilibrium in Competitive Competitive Insurance Insurance Markets: Markets: An Essay in the Economics of Imperfect Informatio Information”). n”). Is the lack of annuities annuities due to this adverse selection selection problem? problem? Not completely completely clear. clear. Adverse selection is also operative in other kinds of insurance markets such as for health and life insurance insurance and we see such markets existing existing around around the world. Why did it just “kill off” the annuity markets? markets? Some argue that annuity annuity markets don’t exist not becuase of adverse selection selection but because Social Security Security and pension plans have taken their place. No really good information information on who strong annuity annuity markets were prior to the advent of Social Security Security and pensions, but more on that later. later. Also, problem with private annuities markets providing fixed real annuity annuity in presence of inflation, inflation, and risks associated with annuity companies going out of business, makes them still relatively risky investments. E. “Informal” “Informal” alternative alternativess to Social Security Security and pensions: the extended family/co family/communi mmunity ty as a risk-pooli risk-pooling ng Social Security Security system. Estelle Estelle James, in a forthcomin forthcoming g book, claims that approximately approximately 60% of the world’s world’s population population receives no significant significant retirement retirement benefits benefits from a “formal” “formal” pension or security security system, system, but rather is supporte supported d by the family family and commun community ity transf transfers ers.. Example Example:: in a sample sample of Indian Indian widows widows:: 90% were supported supported primarily primarily by their sons. This systems systems is mostly used in LDC’s LDC’s in Asia, India, Africa Africa and Latin

America. Even Korea (both north and south) have a relatively miniscule Social Security systems, and in these socieities (similar to China) one’s children, and specifically one’s son, is the primary “Social Security system”. (Anecdote: (Anecdote: Korean grad student student at Wiscons Wisconsin, in, Chong-Bum Chong-Bum An, had good job offer offer at a US universi university ty,, his father father came to attend attend his graduation graduation and contracte contracted d stomach stomach cancer, cancer, and his stomach stomach was immedia immediately tely removed. removed. After that requiring requiring feeding every few hours and continuous care. care. Chong-Bum Chong-Bum quit his position, position, returned returned to Korea to take care of his father, living together with him, his wife and children in a small apartment in Seoul. Recent paper by Namkee Ahn showed that incentive to have son is so strong in Korea that new technology allowing selective selective abortions abortions have increased male/fema male/female le birth ratios from 1.04 in 1980 to 1.13 in 1989. These are the kinds of perverse perverse effects effects (in addition to the incentive in India, Mexico, Mexico, etc. for having too many children) children) of not having an adequate formal Social Security Security system). system). Remaining Remaining 40% of world population, population, primarily primarily in developed developed OECD countries have “multiple “multiple pillar” formal pension/retir pension/retirement ement systems. systems. Informal Informal systems systems are now starting to break down for the same reasons they broke down historically in Europe in the 19th century: (Harrie Verbon, the Evolution industrializati ization, on, the move from primarily primarily agricultu agricultural ral Evolution of Public Public Pension Pension Systems Systems) industrial to urbanize society, the emergence of nuclear family and highly mobile labor with relatively weak community bonds. Predict that ultimately all societies around the globe will ultimately move to formal systems, although family transfers will always be an important source of flows they seem to decrease in importance in modern societies. societies. (defer (defer to Borsch-Supan Borsch-Supan,, see Kotlikoff Kotlikoff study, study, etc.) In U.S. there has been a marked decline decline in the extended extended family family.. Fraction Fraction of aged living with with children declined declined from 31% in 1950 to 9% in 1950. By 1983, fewer than 3% of elderly elderly households households received received income from their children, and overall the fraction fraction of elderly elderly income income from children amounted amounted to less than 1%. So in practice, informal informal systems relative relatively ly small in U.S.: is this cause or effect of expanded formal systems, i.e. social security and pensions? F. “Multiple pillar” formal systems (in order of importance as a source of retirement income): 1. Social Security/public pension: mandatory, universal coverage 2. private/occ private/occupati upational onal pensions: pensions: usually usually mandated by firm for its employee employee but not firms not mandated by government to provide pensions (except for France) coverage not universal but a large fraction in some countries such as U.S., Netherlands, etc. 3. individual individual personal personal savings savings accounts, accounts, tax-deferr tax-deferred ed annuitites: annuitites: IRA’ IRA’s (Canada and U.S., France, Switzer Switzer-land, UK) 4. Family Family transfers transfers G. Summary of Social Security systems: main features, details of systems in U.S. and Netherlands. H. Summary of Pension plans: main features, details of systems in U.S. and Netherlands

1. Source on European European pensions: pensions: J.A. Turner Turner and L.M. Dailey (1991) (1991) Pension Pension Policy: An International International Perspective Covers 9 countries with substantial private pension systems: U.S. Canada, Japan, Nether-

lands, UK, Australia, Australia, France and West West Germany. Germany. Contains Contains a specific specific summary of pension pension system in Netherlands by Kees Zweekhorst and Piet Kiezer. 2. Source on U.S. pensions: O. Mitchell “Trends in in Pension Benefit Formulas and Retirement Provisions” in J.A. Turner and D.A. Beller (1992) Trends in Pensions also Kotlikoff and Smith, (1983) Pensions in the American Economy.

3. Two main types of pensions: pensions: defined benefit benefit vs. defined contribut contribution. ion. DB plans specify specify a benefit rule as a function of wage history and years of service: firm bears residual risk of cost of providing pension benefits. benefits. DC plans specify a fixed contribution contribution rate (possibly (possibly augmented augmented with matching employer employer contribution) and funds are invested in securities (stocks and bonds) whose ultimate accumulated value is uncertain. uncertain. Upon retirement retirement employee can either either collect value as a lump-sum lump-sum (in some cases, e.g. Japan) or the value of the portfolio is converted to an annuity and paid out over the person’s remaining lifetime lifetime (e.g. TIAA/CREF) TIAA/CREF) Thus, under DC employee bears residual residual risk of investment investment portfolio portfolio performance over his working years. In reality, DB plans aren’t riskless either, since often benefits (in the U.S. but less often in Netherlands) are specified in nominal terms rather than being automatically inflation-ad inflation-adjuste justed. d. Employee Employee also bears risk that firm could go out of business, or be taken over by another company that would cash in its pension fund and reduce pension benefits ex post. In U.S. 1974 ERISA legislation (described below) is designed to reduce some of these risks. 3. Start with with U.S. pensions system, system, then look at Europe, and Netherlands Netherlands.. Great diversity diversity:: huge number number of alternative plans. My impression is that there is more uniformity in pension terms in Netherlands. H-USA Pensions Pensions in U.S. can be traced back to 19th century century (American (American Express, 1975, first formal pension plan) plan) but really took off after 1942 tax act granted special tax breaks to firms that created pensions, and 1949 Supreme Court decision making pensions a mandatory negotiating topic in collective bargaining agreements. agreements. Number of plans increased increased from 9,370 in 1946 to 616,642 in 1980. Fraction Fraction of working population population covered covered by pensions increased from 17% in 1940 to 52% in 1970, but coverage has remained fairly flat since 1970, with a recent tendency tendency towards towards decline. Bloom and Freeman (1992) “The Fall in Private Pension Coverage Coverage in the U.S.” showed that decline in unionization and weakening economic position of less skilled American men during 1980’s (Reagan and Bush years) was associated in a fall in coverage rates, document a 10 percentage point drop from 1979 to 1988 in the proportion of workers eligible for pension coverage in BLS data on medium and large establishment establishments, s, from 91% in 1979 to 81% in 1988. After the 1974 Employee Retirement Retirement Security Security Act (ERISA, a landmark pension legislation designed to increase equity and reduce risks of failure of private

pension systems requiring minimum vesting and participation standards, imposed minimum funding standards, rquired rquired plan termination termination insurance insurance for DB plans) we see a big increase increase in defined contribution contribution vs. defined benefit benefit,, (DB incr increase eased d by 6,725 6,725 plans plans per per year year vs. DC of 35,11 35,118, 8, so by 1980 1980 65% of all all plans plans were were DC vs. 35% DB. However in terms of number of participants, participants, DB is still still predominant: predominant: in 1977 74% of particpants particpants were covered covered by DB, 25% by DC, by 1980 65% DB, 35% DC, and by 1987 68% of covered covered workers were enrolled enrolled in a DB plan vs. 68% in a DC plan (39% of workers were enrolled in at least 2 plans, 13% were enrolled in 3 or more plans. Overall, Overall, number of people covered covered by DB decreased decreased from 30 million to 28 million million from 1980 to 1987 whereas number covered by DC increased from 18.9 million to 35 million. I. Specific Specific pension plan rules: IBM and Wisconsin Wisconsin Retirement Retirement System J. Summary Summary of accrual accrual patterns patterns for pensions: pensions: incentives incentives to stay with the firm until vesting and early retirement retirement age, substantial incentives to leave firm after normal retirement age III. Theoretical explanations for the existence of social security and pensions

K. Theoretical explanations for government provision of public pensions L. Theoretical explanations for for firm provision of private pensions