Findings

Impact of working longer

The first deliverable for the ‘Pension savings, systems and financial education’ research field is a report on the impact of working longer on pension income in five European countries (PDF, 476KB): Estonia, Finland, Hungary, the Netherlands and Poland. The paper assesses the impact of these policy reforms on the financial well-being of the elderly in these five countries and shows the diversity of the policy measures taken in the various countries. Furthermore, it analyses the financial incentives to work longer and to postpone claiming pension benefit and addresses the question of how attractive these options are. It also analyses how increases in life expectancy and survival probabilities affect pension incomes.

Economic growth and funded pension systems

The second deliverable for this research field is a NETSPAR discussion paper on Economic growth and funded pension systems (PDF, 941KB). It explores the impact of deeper capital markets caused by growing pension savings and examines the potential positive effect on economic growth by allowing firms that are more dependent on external financing to grow faster. This effect is studied using data on 69 industrial sectors in 34 OECD countries for the period 2001–2010 through a difference-in-differences approach that interacts financial development with industry dependence on external finance.

Intragenerational changes in pension inequality

The third deliverable comprises four working papers on intragenerational changes in pension inequality due to shifts in pension systems, for example from defined benefit (DB) to defined contribution (DC) schemes and from mandatory funded pension schemes to system where more choice options are available. The situation in four European countries, Estonia, Hungary, Finland and Poland, is explored.

Estonia

This paper uses a cohort microsimulation model to analyse intragenerational distributional effects of a shift from a defined benefit pay as you go pension system that includes flat rate component and length of pensionable service component to a pension system with contribution based insurance components in the PAYG scheme and an additional compulsory funded pension scheme. Estonia was among the first European countries to shift partially from a pure PAYG scheme to fully funded financing in 2002. In addition, contribution points reflecting total lifetime earnings were introduced into the PAYG scheme in 1999.

The contribution history is used for 1999–2010 and information on the participation in the funded pension scheme of a full cohort of men, born in 1980, from the Estonian National Social Insurance Board to simulate the distribution of future pensions under alternative pension schemes taking into account economic and demographic changes.

The results show that in the case of large inequality of labour earnings and high long-term unemployment rates, such as in Estonia, introduction of very strong link between contributions and future pensions leads to considerably higher inequality of pensions. Simulation results suggest that the inequality of old age pensions more than doubles when the reforms mature. The inequality in replacement rates on the other hand decreases.

Finland

Many elderly people could markedly increase their standard of living by releasing housing equity. Purchase of a life annuity would increase the benefits of this release. Focusing on the Finnish case, this paper analyses the fiscal implications of different forms of housing equity release. It takes into account the fact that most households have most of their wealth in the form of owner housing and that housing enjoys a tax-favoured status relative to most other forms of consumption and savings.

The research finds that even tax free life annuities may well increase aggregate tax revenue relative to a situation where private annuities are not available. This is because the possibility to annuitise financial savings increases the opportunity cost of housing wealth inducing households to increase non-housing consumption relative to (tax-favoured) housing consumption. Reverse mortgages, in contrast, are likely to decrease tax revenue. This is because they make housing consumption all the more attractive.

Hungary

A simple cohort model was used to project current per capita age-profiles of labour income and consumption to the future and combine them with the expected future age composition of society. Hungarian data was then applied. Due to a shrinking and ageing population this exercise predicts a growing gap between labour income and consumption, which have to be covered by asset-based revenues.

Two balancing items are applied, a windfall capital endowment in the base year and a gradual capital accumulation through higher savings and by how much the household economy, an integral but unregistered part of modern economies, can absorb the effects of ageing is quantified. In addition, the model is also fed with 1995 age profiles. The two decades between the mid-1990s and the mid-2010s offered a special demographic opportunity for Hungary. This period coincided with the botched pre-funding experiment in the public pension system, illustrating an important but missed opportunity.

Poland

The paper analyses the distributional effects of the Polish old age pension reform introduced in 1999. Following a benchmark Mincer earnings equation, and using a newly developed microsimulation model it projects future pension benefits for males born in the years 1969–1979. The findings are that inequality of predicted first pension benefits measured by the Gini coefficient increases from 0.119 to 0.165 for cohorts of men retiring between 2036 and 2046.

The observed increased inequality of pension benefits is due to the decreasing share of initial capital that is based on a more generous DB formula in the total accumulated pension capital. At the same time, inequality in replacements rates decreases due to a stronger link between contributions paid through the entire working life and pension benefits.

Optimal management of macro-economic risks across generations

The fourth deliverable, a working paper on optimal management of macro-economic (PDF, 876KB), explores how to ensure stable retirement incomes. This challenge has increased markedly in the last decades due to volatile financial markets, falling interest rates and the withdrawal of employers and external insurers as risk bearers of systematic financial and longevity risks.

To address this challenge, Personal Pension with Risk sharing (PPR) is introduced. This PPR combines the best of defined benefit and defined contribution pension systems. In particular, PPR features transparent bookkeeping, clear property rights based on market valuation of financial assets, insurance of longevity risk and adaptable investment and pay-out profiles customised to individual circumstances.

The key to the pension innovation of PPR is the combination of two elements. The first element is unbundling the investment, (dis)saving and insurance (or risk-sharing) functions of pensions. The second is market valuation of financial risks by defining financial property rights in terms of personal investment accounts.

The combination of unbundled functions and market valuation of financial risks allows for tailoring systematic and idiosyncratic risks to personal features and the macroeconomic environment. This innovation facilitates communication about risks and pensions, strengthens individual ownership, prevents conflicts of interest within an insurance pool, and facilitates portability of pensions.

Experiments on pension communication

Individuals are increasingly bearing greater responsibility for their own financial well-being during retirement. People face more and more decisions on how much to save for retirement, on how to allocate retirement wealth and on what insurance products to buy. However, individuals find it very hard to navigate financial and insurance markets, and the consequences of mistakes can be substantial. This raises the question how we can promote efficient life cycle financial planning in a cost-effective manner.

This research explores how pension plans can best communicate and frame risk and project pension benefits and replacement rates in order to help individuals make good saving, investment and reporting standards for pension funds and individual pension plans.

The paper ‘Pension awareness, pension communication, and choice architecture’ (PDF, 589KB) gives an overview of what we know about pension knowledge, involvement in pension decisions, and the quality of pension related decisions made by individuals and households. It emphasises heterogeneity and compares the Netherlands with Italy, and other countries.

It focuses on what experiments and observational data tell us about the effectiveness of different forms of communication and choice architecture for improving pension decisions. The main conclusion is that information alone is not enough – offering choices at the right time, in the right format, and in the right context is much more effective to get people involved and stimulate them to make decisions that are in their own long-term interest.

The paper ‘Seven ways to knit your portfolio: is investor communication neutral?’ (PDF, 648KB) focuses on the role of communication for the gender gap in financial and pension literacy. The concept of familiarity is used in finance theory to explain apparent paradoxes in people’s behaviour, such as the home bias in portfolio choices. This study investigates whether (lack of) familiarity with the language of financial consumers may contribute to an explanation of the well-documented gender gap in financial decision-making.

Using an interdisciplinary framework that combines insights from behavioural economics, finance, social psychology and applied linguistics, the paper analyses the metaphors used in websites that target beginning retail investors in three different languages: Dutch, Italian and English. In all three languages, the metaphors used appear to come from the same conceptual domains; namely, war, health, physical activity, game, farming and the five senses.

As these domains refer to worlds that are predominantly masculine, we conclude that the language used to address financial consumers may give rise to feelings of familiarity and belonging among men, while creating feelings of distance and non-belonging among women.

Policy recommendations on private saving plans

Older people differ in terms of pension and labour incomes, financial wealth, household composition, social networks, housing, health and human capital. Policymakers require in-depth knowledge about groups of people that are not well prepared for retirement, so that they can target these groups in their social policies (eg pensions, welfare, long-term care, housing) and alleviate potential adverse welfare effects of policy reforms (such as pension reforms). In this connection, pension systems are intimately related to labour markets and the health status of the population.

European Insurance and Occupational Pensions Authority (EIOPA) has recently proposed to introduce standardised Pan European Personal Pension products (PEPPs) that would be available in the accumulation phase, jointly with national personal pension plans. The research project explores the potential for such private saving programmes and private and public insurances to improve old-age incomes and avoid poverty risks in old age of various heterogeneous individuals.

This paper, Analysis of the standardised Pan European Personal Pension (PEPP) (PDF, 487KB), analyses the PEPPs from the perspective of the academic literature and proposes to categorise product characteristics, both in the accumulation phase as in the decumulation phase. The paper explores the option to use the concept of personal pensions with risk sharing that was proposed by Bovenberg and Nijman (2015) to incorporate design features of the decumulation phase in the PEPP itself. The paper concludes with a comparison of the PEPP proposal with existing regulation in four European countries and a discussion of the potential impact of the PEPP proposal on PPP provision these countries

Reporting practices for pension funds

This working paper on reporting practices for pension funds report (PDF, 7.1MB), proposes a method for projecting pension benefits, deriving from defined contribution (DC) pension plans and other funded products, at retirement. The projections highlight how the current choice of asset allocation impacts on future potential retirement outcomes. The latter are compared with a money-back benchmark so as to clarify the trade-off between risk and return.

After the initial projections, the pension plan revises its forecasts of retirement benefits on a yearly basis as a function of its own realised returns. Previous shorter-term projections are also compared to shorter-term ex-post performance. This simple method is a step towards an industry-reporting standard that responds to regulators’ quest for helping investors monitor the risk of their future pension.

Intergenerational risk sharing

More private retirement saving has become necessary to maintain old-age incomes when public pensions are being cut under pressure, either as a result of the debt crisis or due to longer-term pressures of population ageing. Governments are curtailing the role they play in pension insurance in many countries. At the same time, corporations are withdrawing from their role as sponsor of defined-benefit plans.

As a result, in many countries, individuals have to resort to individual defined-contribution plans. In these plans, individuals themselves are responsible for planning how much to save for retirement, how to invest their savings in the capital market and benefit optimally from risk premia without running excessive risks. Private pensions are exposed to financial-market risks and this raises the question how these risks can best be managed.

The aim of this paper, the allocation of financial risks during life cycle (PDF, 2.3MB), is to measure how financial shocks – equity market, interest rate or inflation shocks – affect different generations of participants in individual and collective pension schemes and to explore the effects of risk-sharing rules in collective pension plans.

We show that an individual pension scheme, by using a life cycle investment strategy, can largely replicate the allocation of traded risks across generations of a collective pension scheme that gradually adjusts pensions after financial shocks. Collective schemes can shift financial risk to generations that will participate in the future, whereas individual accounts cannot. In the current institutional setting this shift of traded risk in collective contracts to future generations is limited.

Collective pension plans can lift borrowing constraints for young generations and thus enable them to combine a high exposure to equity risk with some protection to interest risk. Collective pension schemes are able to reallocate non-traded risks, such as inflation risk or macro longevity risk, among the participants to obtain a more efficient distribution of risk across generations. In schemes with individual accounts, risk sharing is limited to risks traded on financial markets. If inflation risk becomes tradable, for example as a result of the issuance of inflation-linked bonds by governments, individual contracts can provide similar protection against inflation risk.

Policy Brief

MoPAct Policy Brief 3 – Improving private pensions and retirement planning (PDF, 277KB)