Pensions and the role of the State Massimo DAntoni Dept of - PowerPoint PPT Presentation

Pensions and the role of the State Massimo D’Antoni Dept of Economics and Statistics, University of Siena Course of Public Economics Academic Year 2013-2014

Some introductory concepts

The functions of a pension system A pension system can be viewed as a transfer mechanism among groups / generations, as it transfers resources from the active to the inactive (old, survivors, poor, inable individuals) a financial instrument as it smooths income and provides insurance We can identify several functions of a pension system ◮ consumption smoothing ◮ insurance ◮ poverty relief ◮ redistribution Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Two families of pension systems Fully funded (FF) future payments are secured by the cumulation of financial assets. The individual is entitled a share of the assets, which is converted to an annuity at retirement Pay-as-you-go (PAYG) a direct transfer of resources from the active to the inactive population. The individual relies on a "promise" of the State on future payments Note that ◮ a PAYG system requires that an intergenerational pact is enforced, hence an enduring public authority is needed, and its objectives are not usually limited to insurance / income smoothing ◮ in principle, the distinction funded / pay-as-you-go is not necessarily overlapped to the distinction private / public, as a public system may be partially funded ◮ in a PAYG system, what each generation receives is not constrained by the amount of previous savings / value of assets ◮ in a public system, the presence of a precautionary fund is superfluous as solvibility is granted by the continuity of the state Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Public expenditure on pensions Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Historical evolution ◮ the old are supported by their families ◮ mutual help organization and other volutary associations ◮ involvement of the State is required by insolvency and insu ffi ciency of voluntary solutions; it implies at a minimum ◮ mandatory savings ◮ a guarantee of a minimum return ◮ Germany: in 1889 (Bismark) introduces a mandatory earning-related pension system ◮ An alternative approach: means-tested system financed with general taxes—Denmark (1891), New Zealand (1898), Australia and United Kingdom (1908), Canada (1927) ◮ USA: in 1920s means-tested systems in many states, in 1935 (New Deal) the OASDI (Old Age Survivors & Disability Insurance), popularily known as social security , is started ◮ expansion of social security after the 2nd World War Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Defined contribution vs defined benefit schemes Defined contribution (DC) each member pays into an account a fixed fraction of his or her earnings; benefits at retirement, given life expectancy and the rate of interest, are determined by the size of his or her lifetime pension accumulation, preserving the individual character of a person’s lifetime budget constraint Defined benefit (DB) a worker’s pension is based on his / her wage history, possibly including length of service; pensions are usually based on a person’s wage in his / her final year, or few year (although it can be based on a person’s real or relative wages over an extended period), and is tipically wage-indexed until retirement. A recent innovation (Sweden, Italy): Notional Defined Contribution (NCD) it mimic funded DC schemes by paying an income stream whose present value over the person’s expected remaining lifetime equals his / her accumulation at retirement, but with an interest rate set by government rules (typically linked to GDP growth), not market returns. Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Why is there a role of the State?

Public role in pensions This includes ◮ Mandatory contribution to the pension system. Why? ◮ Myopia: individuals do not correctly perceive their future needs, they do not discount correctly future income ◮ Free-riding counting on the fact that society will take care ( Samaritan’s dilemma ). Two conditions ◮ other individuals are altruistic ◮ they cannot credibly commit not to intervene ex post to support the old who have not saved enough ◮ Self-control ( quasi-hyperbolic preferences ) ◮ Mandatory annuitization. Why? ◮ Myopia (wrong perception of the fact that annuitization is always beneficial) ◮ Adverse selection ◮ Guaranteed minimum return on pension savings and regulation of private funds ◮ Macroeconomic instability, inflation etc. non insurable risks ◮ Di ffi cult to ascertain long term solvibility of investors ◮ Direct provision of benefits ◮ Necessary in the case of a PAYG system Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Myopia Individuals discount too much their future needs: their decisions are based on a discount rate higher than the "true" rate U ( C 1 ) + δ U ( C 2 ) s.v. C 2 = ( R − C 1 )(1 + r ) First order conditions: U ′ 1 ( C 1 ) = (1 + r ) δ U ′ ( C 2 ). The lower δ , the larger the optimal value of C 1 . C 2 E 1 E 2 C 1 Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Quasi-hyperbolic preferences ◮ We usually assume exponential preferences, or U ( C 1 ) + δ U ( C 2 ) + δ 2 U ( C 3 ) + . . . in this case, the MRS between C t and C τ does not change as we get close to t : we have time consistency . ◮ Consider alternatively that the current period is given more weight than future periods (see Laibson, 1997) � � δ U ( C 2 ) + δ 2 U ( C 3 ) + . . . U ( C 1 ) + β 0 < β < 1 in this case we have time inconsistency , because in period 2 the utility is � � δ U ( C 3 ) + δ 2 U ( C 4 ) + . . . U ( C 2 ) + β hence the MRS between C 2 and C 3 is di ff erent if it is calculated in period 1 or in period 2 ◮ Quasi-hyperbolic preferences imply procrastination . Today the individual underestimate the cost of reducing consumption tomorrow to increase consumption later on. Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

An example of procrastination Consider an action involving an immediate cost c and a flow of benefits x in future periods. The utility—calculated in period zero—from taking the action in t is � �  δ  βδ t [ − c + δ x + δ x + . . . ] = βδ t   with t > 0 1 − δ x − c   V ( t ) = � �   δ   δ x + δ 2 x + . . . − c + β = β 1 − δ x − c with t = 0  ◮ Assume that x > c (1 − δ ) /δ , so that the present value of benefits exceed the cost; ◮ we have that V ( t ) > V ( t ′ ) when t ′ > t > 0, i.e. there is no benefit from delaying the action with t > 0 ◮ however, V (0) < V (1) as long as x < c (1 − βδ ) /βδ , which may well be compatible with the previous condition if β < 1; in this case, the best timing for the action is period 1 (tomorrow) ◮ for example, assume δ = . 8 and β = . 75; with 2 3 c > x > . 25 c we have at the same time V (1) > V ( t ) with t > 1 and $V(0) > V(1) Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

An example of procrastination /2 ◮ Although the individual knows that it is optimal to carry out the action in period 1, once in period 1 the individuals will find it optimal to delay the action to period 2, and so on: the action is never carried out! ◮ If the individual is sophisticated, he / she will find it optimal to commit to carry out the action in period 1 by fixing a deadline (he / she will self impose a penalty for not respecting it) ◮ note that the possibility of procrastination is reduced if the action can be carried out at longer intervals; for example, consider that the action is possible only after 5 intervals, so that the action is delayed if V (5) > V (0), but this requires x < (1 − δ )(1 − βδ 5 ) c = . 37 c βδ (1 − δ 5 ) so that procrastination is much less likely to occur On procrastination see also Akerlof (1991) "Procrastination and obedience" Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena

Comparison among pension systems Assessment should be made with reference to all objectives: ◮ consumption smoothing ◮ insurance ◮ poverty relief ◮ redistribution Usually, comparisons consider ◮ return of the pension investment ◮ the e ff ect of the pension system on the economy ◮ savings ◮ labour market ◮ risk exposure ◮ administrative costs Massimo D’Antoni Course of Public Economics, Academic Year 2013-2014 Dept of Economics and Statistics, University of Siena