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Modelling pension futures: two ways of thinking about sustainability

Coverage of German politics – let alone German pension politics - tends to be rather thin in the British press (mainly the FT and the Economist). So it may come as a surprise to learn that pension reforms were a big issue in last year’s German federal election (as in the recent presidential election in France). During the campaign, two of the parties in the present coalition made it clear that they would not support any action to lower the level of pension benefits or to legislate further increases in the retirement age, and once in power, the new coalition quickly announced that no new reforms of the mandatory public pension system would be legislated till after 2025. The background to this announcement is the failure of a special commission set up in 2018 by Merkel’s Grand Coalition to reach a consensus on a new round of pension reforms. The commission’s brief was to follow up on major reforms enacted between 2001 and 2007, which inter alia introduced a self-stabilizing mechanism to peg benefit levels to the ‘system dependency ratio’ (so that that an increase in the ratio of pensioners to contributors would act to push down benefit rates).  In 2018, however, when the commission was installed, the government brought in so-called ‘stop lines’ to ensure that adverse changes in benefit and contribution rates would not be too large or too rapid. Although it would be unfair to say that the present government has sidestepped the need to do anything about pension reform (they have announced minor changes in benefit rates and a decision to create a large reserve fund to help stave off future increases in contribution rates), the failure of the commission has allowed them to postpone some of the more contentious and difficult issues. The decision has dismayed some German pension experts, who have recently drawn attention not only to the unsustainability of the public pension system in its current configuration, but also to its lack of generational fairness

Germany of course is not unique in this respect. A recent report (2021) from the OECD chose to highlight the problem of sustainability by comparing the fiscal impact of what they call COVID legacy debt (= interest payments on the additional public borrowing required to finance COVID-related spending during the pandemic) with the pressures exerted by the future costs of population ageing. It is intended as a timely reminder of the importance of what they call the ‘long game’ – how to handle long-term structural challenges in the public finances that may be overshadowed by more immediate and urgent crises and are all too readily shifted onto the shoulders of a future government. In most countries, the impact of the legacy debt is, as they say, ‘dwarfed’ by the predicted fiscal pressure exerted by population ageing over the next 40 years (measured by the increase in revenue as % of GDP that would be required to stabilise the debt-to-GDP ratio). Germany’s position, moreover, is by no means as bad as that of Italy or France (let alone Japan or S Korea). All this perhaps is familiar, an old story with some updated data collection and modelling to make a point about the need to grapple with long-term structural challenges.  

Also last year the International Monetary Fund published a report on pension reform in Europe, this time including intergenerational equity as well as sustainability in their analysis.  As with the OECD, the pandemic is highlighted as an opportunity to raise structural issues around public finances, with the focus in this case narrowed down to pensions systems.  For several years prior to COVID, European governments had been spending and borrowing in a low interest rate environment which “reduces the cost of public debt and may make public finances look more sustainable and generational disparities less stark”.  Over the same period many of them had introduced reforms designed to improve the sustainability of their public pension systems.  So, asks the IMF, have the reforms done enough? have they been fair and equitable?  what more has to be done?

What is interesting about the IMF report is the way they incorporate this second question (fair and equitable?) in their overall analysis.  The central component in their analytical framework is a metric for assessing public pension systems in terms of actuarial fairness and intergenerational equity as well as sustainability. The Proportionality Measure (their term) is the ratio of the present value of a lifetime’s pension contributions to a lifetime’s benefits for a particular birth cohort[1]. The point of the measure is to define actuarial fairness for a particular cohort. If the ratio is equal to 1 then the system is actuarially fair for that cohort.  In other words, and quite independently of whatever redistribution occurs between income groups within particular birth cohorts, we can say that under these conditions for the cohort as a whole the system is actuarially fair. If the ratio is greater than 1, it means that the value of the contributions made by that cohort is less than the benefits they will receive on retirement.  For the system to be sustainable, the present value of benefits must equal (or be less than) the present value of contributions for all relevant cohorts – which will include individuals who may not yet be in the workforce.  By this definition a system can be sustainable on aggregate even though different cohorts are treated differently in terms of actuarial fairness. The report assesses intergenerational equity by asking whether or not the balance between the present value of contributions and benefits changes across different cohorts (generations).  Only if the balance stays the same is the system intergenerationally equitable.

The core of the analysis is a series of estimates of the Proportionality Measure for three different time points (2009, 2018, and 2021) for successive birth cohorts running from 1930 to 2000.  The value of the measure is changed by legislated reforms, and as they say, there was a big push for reform in the decade following the 2008 Global Financial Crisis when interest rates were very low.  Consider, for example, the effect of an increase in the pensionable age; by increasing the value of total lifetime contributions, it will reduce the balance of benefits to contributions (ceteris paribus) and improve actuarial fairness. The Proportionality Measure is used to gauge how the sustainability and fairness of European pension systems were affected by the reforms.

The big picture for the IMF starts from the position that “current retirees receive lifetime benefits that exceed their lifetime contributions more than twofold”.   The overall effect of reforms legislated in the decade to 2018 was to reduce the lifetime benefit-contribution ratio to nearly 1.5 for ‘younger generations’.  In their words, the reduction in the Proportionality Measure from >2 to 1.5 goes “halfway toward long-term sustainability”.  An improvement in sustainability, however, is not the same as the achievement of sustainability, and even after the reforms the present value of the projected benefits that would be received by younger generations still exceeded the present value of their lifetime contributions.  What happened next, i.e. in the years between 2018 and 2021 is that “subsequent reforms and reversals have partly eroded these gains and, as of 2021, the lifetime benefit-contribution ratio stands at about 1.7 for younger generations”.  In what they call “advanced Europe” (e.g. Germany), reversals can be seen in moves to rollback earlier increases in retirement ages and suspend the application of sustainability factors.

The overall conclusion is that even when the recent reforms are taken into account, younger generations bear most of the cost of the improvements in sustainability. As things stand, however, most of Europe’s pension systems (including Germany’s) are not sustainable, which means that further ‘deep’ reforms are needed.  For the authors of this report, the central political problem is how to share the costs of another round of reforms across the generations.  In their words, “appealing to shared principles of fairness and equity across generations, spreading the adjustment more equally across all generations is critical to foster greater political acceptability”

[1] The calculations set the discount rate as equal to GDP growth.


About the Authors:

Kenneth Howse is a Senior Research Fellow at the Oxford Institute of Population Ageing. He is also a key member of The Oxford Programme on Fertility, Education and the Environment (OxFEE). 

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