Lecture 1: Retirement institutions
Why do we have retirement institutions?
They satisfy some objectives from the perspective of individuals...
● Consumption smoothing: individuals will have to work during their lifetime in order to
finance their retirement, and RI can help them with that.
● Insurance for lifetime risks
- Longevity
- Disability
● Correcting behavioral failures
- Lack of savings discipline
- Financial literacy
...and from the perspective of government:
● Income redistribution
● Poverty relief
Three-pillar system
PILLAR 1: State pension. Is the “pension for all” provided by the government,, which relies on
the fact that an individual is related to a country.
PILLAR 2: Occupational pension. Is the one that is provided by an employer. They are also
known as company or employers' pension plans.
→ Occupational pension schemes provide a regular income after retirement.
1
,PILLAR 3: Private pension. Is a plan into which individuals contribute from their earnings,
which then will pay them a private pension after retirement. It is an alternative to the state
pension.
Usually, individuals invest funds into saving schemes or mutual funds, run by insurance
companies.
Pension finance methods
1st PILLAR: Pay-as-you-go
Contributions workers = Benefits for retirees
● Main problem: ageing and rising dependency ratio (=Retirees/Workers)
● Solution:
- Higher contributions, and/or
- Lower benefits
2nd PILLAR: Funding
Savings + Investment Returns = Pension wealth at retirement for yourself
● Main problem: Low rate of capital market return in the 21th century
● Solution:
- working longer, and/or
- more savings
Can we substitute these methods?
Pension systems in most countries aim to deliver a pension equal to 70% of average
income before retirement.
However, countries differ enormously in relative size of paygo and funding.
Replacement rate → refers to the % of an individual's annual employment income that is
replaced by retirement income when they retire.
They are often lower than 100% since older individuals are thought to have fewer living costs
and expenses, such as a mortgage or children to raise.
Pension Replacement Rate = Pension / Average income
Substitution between PAYGO and funding:
2
,More paygo implies:
- less need to save for pensions
- less pension wealth
Note that countries differ enormously in relative size of PAYG and funding.
Illustrative example
Advantages of the combination between PAYG and Funding
Risk Diversification → Don’t put all eggs in one basket!
There are multiple risks in pensions:
Demographic risks in paygo plans
● Ratio of workers and retirees: the less workers there are, the higher the contribution
costs for retirees.
● Design of paygo system may lead to risk sharing between workers and retirees:
- Economic growth per capita
- Fertility shocks
- Longevity trend
Financial market risks in funded plans
● Capital market rate of return
● Inflation
● Collective savings plan (e.g. pension fund) may organize risk sharing
→ a pension system with a specific mix of paygo and funding defines its degree of exposure to
risks.
3
, Sum of 1st and 2nd pillar: Gross and Net Replacement Rate
Pension systems have:
- multiple purposes,
- diverse institutions,
- diverse histories,
- diverse politics, and
- diverse constraints.
→ Thus there is no single best-practice. Also, pension systems differ widely across countries -
this is as it should be.
What may explain worldwide diversity?
Path dependency: Pension design choices in the past persist in the present.
Pension institutions are a key example of path-dependency.
Why? They are resistant to change.
● Vested interests: Claims on pension payments are build up over a long working
period and paid out after retirement.
● A (pension) plan reform can be painful
- Lower pensions
4
Why do we have retirement institutions?
They satisfy some objectives from the perspective of individuals...
● Consumption smoothing: individuals will have to work during their lifetime in order to
finance their retirement, and RI can help them with that.
● Insurance for lifetime risks
- Longevity
- Disability
● Correcting behavioral failures
- Lack of savings discipline
- Financial literacy
...and from the perspective of government:
● Income redistribution
● Poverty relief
Three-pillar system
PILLAR 1: State pension. Is the “pension for all” provided by the government,, which relies on
the fact that an individual is related to a country.
PILLAR 2: Occupational pension. Is the one that is provided by an employer. They are also
known as company or employers' pension plans.
→ Occupational pension schemes provide a regular income after retirement.
1
,PILLAR 3: Private pension. Is a plan into which individuals contribute from their earnings,
which then will pay them a private pension after retirement. It is an alternative to the state
pension.
Usually, individuals invest funds into saving schemes or mutual funds, run by insurance
companies.
Pension finance methods
1st PILLAR: Pay-as-you-go
Contributions workers = Benefits for retirees
● Main problem: ageing and rising dependency ratio (=Retirees/Workers)
● Solution:
- Higher contributions, and/or
- Lower benefits
2nd PILLAR: Funding
Savings + Investment Returns = Pension wealth at retirement for yourself
● Main problem: Low rate of capital market return in the 21th century
● Solution:
- working longer, and/or
- more savings
Can we substitute these methods?
Pension systems in most countries aim to deliver a pension equal to 70% of average
income before retirement.
However, countries differ enormously in relative size of paygo and funding.
Replacement rate → refers to the % of an individual's annual employment income that is
replaced by retirement income when they retire.
They are often lower than 100% since older individuals are thought to have fewer living costs
and expenses, such as a mortgage or children to raise.
Pension Replacement Rate = Pension / Average income
Substitution between PAYGO and funding:
2
,More paygo implies:
- less need to save for pensions
- less pension wealth
Note that countries differ enormously in relative size of PAYG and funding.
Illustrative example
Advantages of the combination between PAYG and Funding
Risk Diversification → Don’t put all eggs in one basket!
There are multiple risks in pensions:
Demographic risks in paygo plans
● Ratio of workers and retirees: the less workers there are, the higher the contribution
costs for retirees.
● Design of paygo system may lead to risk sharing between workers and retirees:
- Economic growth per capita
- Fertility shocks
- Longevity trend
Financial market risks in funded plans
● Capital market rate of return
● Inflation
● Collective savings plan (e.g. pension fund) may organize risk sharing
→ a pension system with a specific mix of paygo and funding defines its degree of exposure to
risks.
3
, Sum of 1st and 2nd pillar: Gross and Net Replacement Rate
Pension systems have:
- multiple purposes,
- diverse institutions,
- diverse histories,
- diverse politics, and
- diverse constraints.
→ Thus there is no single best-practice. Also, pension systems differ widely across countries -
this is as it should be.
What may explain worldwide diversity?
Path dependency: Pension design choices in the past persist in the present.
Pension institutions are a key example of path-dependency.
Why? They are resistant to change.
● Vested interests: Claims on pension payments are build up over a long working
period and paid out after retirement.
● A (pension) plan reform can be painful
- Lower pensions
4
