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Equitable and Sustainable Pensions
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Chapter 9. Pension Reforms and Risks: Challenges for Pension Systems in Advanced European Economies

Author(s):
Benedict Clements, Frank Eich, and Sanjeev Gupta
Published Date:
March 2014
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Author(s)
Anna Cristina D’AddioThis chapter is based on the author’s previous work with Organization for Economic Cooperation and Development (OECD) colleagues, in particular, Monika Queisser, Andrew Reilly, and Edward Whitehouse. Views expressed represent exclusively the opinions of the author and do not necessarily correspond to the views of the OECD or of the governments of its member states. The usual disclaimers apply.

Introduction

All European countries have arrangements in place to provide income to older people when they retire. Nowadays, spending on old-age pensions is one of the largest social security benefits, equivalent to between 6 and 15 percent of GDP, but this has not always been the case. Originally the size of pension systems was far more limited. Increasing populations meant that the number of working-age people was growing, boosting the labor force, which resulted in higher revenues. In contrast, because of the immaturity of the systems, benefit payments were modest. Therefore, countries began to accumulate reserves, which allowed pension systems to become more generous and to enhance old-age programs. These old-age programs led to the substantial reduction of old-age poverty.

Despite unfavorable economic conditions experienced by most countries in the 1970s, growth in pension spending did not slow down—it even accelerated as a result of fundamental demographic and socioeconomic developments, which are still transforming societies in many advanced European economies. These changes are numerous.

First, the increase in life expectancy (both at birth and at older ages), the decline in fertility rates, and the larger size of the cohorts of baby boomers reaching retirement have resulted in a rapid aging of the population in the majority of advanced European economies. All else equal, these developments mean that pensions are paid for longer periods to an increasing number of individuals, while their financing is left to a shrinking pool of contributors. The financial sustainability of pension systems is thus under increasing pressure.

Second, higher incomes in old age and the preference for leisure over work, together with policies reducing retirement ages, encouraged an increasing share of people to withdraw from the labor market at relatively early ages. The decision to retire is complex and depends on many factors. Beyond individuals’ characteristics and preferences, institutional factors—such as those implicit in social security systems—matter.

Third, the financial, economic, and social crisis will have implications for the ability of pension systems to deliver benefits in the future, regardless of their structures. Falling rates of return will negatively affect the pension entitlements of many retirees now and in the future—especially of those who were close to retirement at the onset of the crisis (OECD, 2009). The recession in many advanced European economies has also caused a large fall in the employment rates of younger people, as well as large increases in their unemployment rates, which has intensified the effect of a shrinking working-age population. With decreasing wages and falling employment rates, the revenues of the system have declined just when rising unemployment and population aging have put increasing pressure on public expenditure. These trends will encumber the financing of pension systems regardless of whether they are prefunded or financed on a pay-as-you-go (PAYG) basis.

Fourth, transformations that occurred in the labor market (such as the increase in the number of people with more precarious or fragmented careers and the increase in the number of unemployed people, especially among the young) might have implications for the adequacy of retirement incomes for future generations of retirees. In the absence of adequate safety nets, many more people than in current experience might find themselves with insufficient retirement incomes because of the strong link between contributions and benefits that now exists in the majority of pension systems across advanced European economies.

Fifth, important societal changes have taken place, among them, rising divorce rates and higher numbers of single parents, the decline in the number of children per family, and the shift away from the model of the single breadwinner. The increase in female labor force participation tends to increase pension entitlements that women build on their own, which is important to combat the higher poverty risk women experience in old age. In contrast, divorce and single-parenthood may increase the risk that women will build insufficient pension entitlements, resulting in higher female old-age poverty. Again, solidarity mechanisms may make a difference for the most vulnerable individuals.

Finally, the majority of advanced European economies have reformed their systems, trying to balance the twin objectives of financial sustainability and income adequacy while at the same time remaining affordable to taxpayers and contributors. These reforms will affect the level and sources of retirement incomes of today’s workers and thereby their future economic well-being.

This chapter is structured as follows: The next section discusses the risks facing advanced European pension systems, while the subsequent section reviews how pension systems have responded to these challenges. The penultimate section analyzes how the objectives of adequacy and sustainability can be balanced. The final section concludes.

What are the Risks for European Pension Systems?

As set out in Chapter 2, public pension spending is projected to increase in most advanced European economies as a result of rapid population aging. The global financial crisis, with its high unemployment, low interest rates, and slow economic growth, added to the risks and pressures facing both PAYG and funded systems, affecting, although to different degrees, the ability of pension systems to deliver adequate retirement incomes and to be sustainable in the long term.

Demographic Changes and the Demographic Risk

Projections show that the majority of advanced European economies face unprecedented population aging although the magnitude, speed, and timing of the aging process vary by country. Both increasing life expectancy and falling birth rates have contributed to the greying of the population during the past few decades, a process expected to continue into the future.

Population aging has financial and economic consequences that have been extensively discussed in the literature. For example, growing public spending on pensions and health care may put pressures on public budgets, compromising financial stability and crowding out other expenditure programs (e.g., those devoted to families with children). An older labor force, if not adequately trained, may be less able to adapt by either moving geographically or occupationally. In turn, changes in the size and structure of the population may affect economic growth: as younger cohorts shrink, the number of people holding jobs falls, and the pool of domestic savings in the economy gets smaller, with negative consequences on productive investment (Burniaux, Duval, and Jaumotte, 2004; D’Addio and Mira d’Ercole, 2005; Oliveira Martins and others, 2005).

With only two, one, or perhaps no children at all, questions about the availability of family caregivers for adults in their old age will become more important (OECD, 2012a). Increases in the number of older people may also cause greater tensions between generations. If intergenerational solidarity breaks down, many might lose. As stated in OECD (2011b, p. 19), “population ageing compounds the threat from the current state of the public finances.” Increased tax revenues will be needed to support growing pensions and health care expenditures, and this tax burden is likely to be borne by younger, shrinking, cohorts.

In summary, even though the pace and the scale of the aging process differ by country, the greying of the population seems ineluctable. Aging may occur either from the top (through an increasing number of pensioners and longer life expectancy), from the bottom (through a reduction in fertility rates), or both, but in all cases it is a challenge. Increases in fertility rates may not immunize a country against the consequences of the demographic risk of pension systems if both the periods over which pensions are paid and the number of pensioners continue to increase. For these reasons, and because it affects multiple domains of modern societies, aging poses a number of challenges for nearly all parts of the social protection system. Countries therefore must act now and take a comprehensive approach across policy fields to deal with aging.

Societal Developments and Social Risks

The role of women

Women’s role in the economy and society has changed deeply during the last few decades. Their increased participation in the workforce has contributed to a move away from the male breadwinner model. The gender gaps in employment and pay have become smaller. More women are building pensions in their own right, and the value of these pensions has increased over time (see OECD, 2012b, 2013b).

However, because of the tight link between contributions and benefits in the majority of pension systems across advanced Europe, shorter working hours, atypical career patterns, and some types of occupations that keep women in lower income during their working years mean lower pension entitlements for women relative to men. The gap in pension entitlements is large: across European countries, pension payments to individuals age 65 and older in 2009 were 34 percent lower on average for women than for men (see OECD, 2013e).

Divorce and single parenthood, both of which have increased over time, may also potentially affect women’s incomes in old age. Single parents tend to have low incomes because of caring responsibilities and lack of affordable child care. With a somewhat offsetting effect, some countries allow pension splitting between couples upon divorce, but these rules are relatively recent.

Taken together, these social and economic developments affect women’s outcomes in the labor market: for women who have full careers, they might result in higher old-age incomes, but for others they may not. Because women also live longer than men, they have to finance longer retirement periods. It follows that they should save more than men for their retirement—which often they cannot do because they earn less. They thus are subject to a higher risk of poverty in old age. Some advanced European economies, such as Sweden, that have reduced or abolished survivors’ benefits may even see—at least for the most recent cohorts of retirees—a worsening of women’s economic conditions in old age.

The economic conditions of the elderly

The economic conditions of older people have tended to improve in many European countries. Data from the OECD Income Distribution database suggest that the risk of poverty measured with respect to the 50 percent of median equivalized household income was close to 8.4 percent late in the first decade of the 2000s among advanced European economies, much smaller than the rate observed in the middle of that decade at about 11 percent, and also smaller than the OECD poverty rate at 12.8 percent (Figure 9.1). These trends vary by country: for example, in Austria, the Czech Republic, Greece, Poland, and Turkey, poverty rates of the elderly increased between the mid- and late 2000s.

Figure 9.1Old-Age Income Poverty Rates, Mid- and Late 2000s

(Percentage of those older than age 65 with incomes of less than half the median equivalized population incomes)

Source: Organization for Economic Cooperation and Development Income Distribution database.

Note: OECD-34 = the 34 members of the Organization for Economic Cooperation and Development.

The largest number of relatively poor persons among those older than age 65 was observed in Greece and Turkey in the late 2000s, while in the Czech Republic, France, Iceland, Luxembourg, the Netherlands, and the Slovak Republic, 5 percent or fewer of the elderly were at risk of poverty in the same year.

The economic conditions experienced by people in old age depend on many factors. The public provision of retirement incomes, particularly the level and coverage of safety-net benefits, is among these—which explains the relatively low risk of poverty of older people in some European countries such as Luxembourg and the Netherlands.1

Changing the thresholds at which minimum pensions are set may substantially affect the number of people who are considered to be poor or nonpoor. As noted in the 2012 European Union (EU) pensions adequacy report, “a relative drop in incomes of elderly people by one-seventh could add another 8.7 million people to the group at-risk-of-poverty, as those with the income currently between 60 percent and 70 percent of median would fall under the 60 percent at-risk-of-poverty threshold,” while “Increasing the relative equivalised income of older people who are at-risk-of-poverty by 20 percent would help to lift around 7 million persons (those between 50 percent and 60 percent of median income), out of poverty (as defined within the EU2020 strategy)” (European Commission, 2012b, p. 75).2

Data from the OECD Income Distribution database suggest that incomes of people over 65 were 86 percent of population incomes in the late 2000s across all European and OECD countries included in Figure 9.1. Older people have above-average population incomes in Hungary, the Netherlands, and Poland. Incomes are above 90 percent of population average in Austria, France, Iceland, Italy, Luxembourg, Portugal, and Turkey. In contrast, incomes of older people are relatively low—less than three-quarters of the population average—in Denmark and Estonia. Incomes in old age are also influenced by the type of pension provisions existing in a specific country.

Public transfers—earnings-related pensions, resource-tested benefits, and the like—make up more than two-thirds of the incomes of those older than age 65 across European OECD countries and across the whole OECD. For example, within European countries in the left panel of Figure 9.2, the largest shares (at 75 percent and more) are observed in Austria, Belgium, Finland, Ireland, and Luxembourg. In contrast, employment and self-employment provide a much smaller proportion of income of around 15 percent to those 65 years and older in the EU15,3 Iceland, and Norway.

Figure 9.2Sources of Incomes of Older People

(Percentage of gross household income, late 2000s)

Source: Organization for Economic Cooperation and Development Income Distribution database.

Note: Income from work includes both earnings (employment income) and income from self-employment. Capital income includes private pensions as well as income from the returns on non-pension savings.

However, averages hide country-specific situations. For example, in Greece, Iceland, Italy, Portugal, and Spain, people age 65 and older derive one-quarter of their income from their work and even more in Slovenia. The reasons for the higher shares of income from work in these countries are diverse. Among those, the age at which retirement is set and having gaps in contribution histories in the public pension scheme do matter (Figure 9.2).

Income from capital—mainly from private pensions—provides the largest share of incomes in Denmark, Iceland, the Netherlands, and the United Kingdom. In these countries, capital income represents about 30 percent or more of the incomes for those age 65 years and older.

Income composition also changes along the income distribution: older people at the bottom of the income distribution are likely to derive their income almost exclusively from public transfers, whereas at the top of the income distribution, private pensions and other capital income might play a greater role. The place of capital in retirement income has been growing and may lead to rising inequality of incomes in old age (see D’Addio and others, 2014).

The Impact of the Crisis on Economic Conditions

The financial, economic, and social crisis has had a profound effect on pension systems and retirement incomes. According to the EU Green Paper on Pensions, “The scale of fiscal deterioration following the crisis is equivalent to offsetting 20 years of fiscal consolidation, implying that fiscal constraints will be very strong in the next decade” (European Commission, 2010, p. 6).

In 2008, when the real rate of return on pension funds was negative across the OECD, at -10.5 percent, pension fund investments lost 23 percent of their value in aggregate (about US$5.4 trillion). Across the OECD, real rates of return were positive in 2009 and 2010 (at 6.0 percent and 1.4 percent, respectively), but they turned negative again in the first half of 2011 (-1.4 percent). Therefore, the investment performance of most countries’ pension funds was negative for the period 2007–11, with an average annual real net return of -1.6 percent. At the end of 2011, OECD pension fund asset values climbed back to a higher level than they had been at the end of 2007.

The crisis also had an adverse effect on the labor market. Unemployment grew steadily in the five years after 2008 irrespective of age group. Among people ages 15–64, unemployment rose by 2.4 percentage points between 2007 and 2011 across the OECD. In the age groups 15–24 and 25–54, the unemployment rate rose by 4.2 and 2.3 percentage points, respectively. Larger increases in the unemployment rates of these age groups have been registered in the EU15 where, conversely, the increase in the unemployment rates of people ages 65 and older has been smaller. Shrinking working-age populations together with high unemployment and lower earnings will reduce the contribution revenue of PAYG pension systems, making it more difficult for these systems to deliver promised pension benefits.

Changes in Advanced European Pension Systems in Response to Risks

The public pension projections presented in Chapter 2 suggest that some countries may succeed in stabilizing (or even reducing) pension expenditures in the future. The same estimates suggest, however, that the impact of population aging on public pension spending is still a substantial challenge for many countries. However, the scale of this problem in the future remains uncertain because the forecasting period is long and the projected values rely on a set of assumptions that may or may not materialize.

Adverse demographic and economic trends are behind the wave of pension reforms that have taken place in recent years in many EU countries. The reforms to retirement income provision are diverse and vary by country. However, recent reforms have often meant a retrenchment from public pension systems.

For workers who earn the average wage throughout their careers until reaching the national pensionable age, the projected average gross replacement rate will be about 54 percent when they retire (OECD, 2013e). Cross-country variations in the replacement rates are, however, large and depend on the pace, timing, and type of pension reforms already implemented or that are to be implemented gradually.

Some countries have implemented parametric reforms, whereas others have completely overhauled their pension systems with more systemic reforms (see Chapter 1 for a fuller discussion of what these entail). The pace of change in retirement income provision appears to have accelerated during the period 2007–11, during and after the financial and economic crisis. The first set of reforms was embodied within economic stimulus packages. Other reforms were also designed to address the structural weaknesses of pension provision that had been highlighted or exacerbated by the onset of the crisis (see also Chapter 1 in OECD, 2012b). More recently, pension reforms have been playing an increasingly important role in fiscal consolidation packages (see OECD, 2013b).

Achieving Adequacy and Sustainability through Longer Working Lives

Raising the statutory retirement age

Most workers leave the labor market well before the official pension eligibility age (Figure 9.3). On average, during the period 2006 to 2011, the effective age of labor market exit was 62.6 years for men and 61.6 years for women across the OECD-member EU countries, whereas the average official retirement age was 64.3 years and 63.1 years for men and women, respectively, in the same countries.

Figure 9.3Average Age of Labor Market Exit, Men and Women, 2010

Source: Organization for Economic Cooperation and Development estimates based on the results of national labor force surveys and the European Union Labour Force Survey

Note: OECD-34 = the 34 members of the Organization for Economic Cooperation and Development. Effective retirement ages are averaged for the years 2006–11. The black bars correspond to the average for the OECD-member European Union countries; the darker grey bars correspond to the OECD average. Official retirement ages are those applicable in 2011.

Because working longer may help to improve both financial and social sustainability, many countries have implemented reforms that aim to extend working lives by increasing the effective retirement age and enhancing incentives to work longer. In fact, the decision to retire (and thus, in most cases, to stop working) depends on a broad range of factors. The literature has identified a set of pull and push factors (Blondal and Scarpetta, 1998; Gruber and Wise, 1999, 2004). One of the factors that plays a key role is the age at which unreduced public pension benefits become available.

Data from OECD (2012b) show that the average official pension age in 1950 was 64.5 for men and just over 63 for women. In the following four decades, official pension ages fell to a low point of 62.7 for men and 60.9 for women in 1993. During that period, 10 OECD countries cut pension ages for men and 13 did so for women. From 1993 onward, the average pension age for men and women began to rise again (OECD, 2011c, 2012b; Chomik and Whitehouse, 2010).

The official pension ages are legislated to increase, in the long term, in many European countries. For both men and women, 65 will be the most frequently occurring long-term pensionable age after a full career based on national rules and legislation. Fourteen countries either have set or are gradually setting the retirement age at 67 or older for men (13 countries for women). For example, Iceland and Norway are already at 67. Italy, which began to link pension age to life expectancy in 2013, and Denmark, which plans to link pension age to life expectancy beginning in the mid-2020s, are forecast to reach nearly age 69 for both men and women in 2050. Finally, Poland and the Netherlands are increasing the pension age for both sexes to 67.

However, even with these increases, the majority of advanced European economies will not succeed in stabilizing the expected duration of retirement.

Figure 9.4 suggests that among advanced European economies only Greece, Italy, the Czech Republic, the Netherlands, the United Kingdom, and Ireland are projected to stabilize men’s expected duration of retirement by 2050, bringing it back to the 2010 level. However, no country except Greece is projected to succeed in bringing the expected duration of retirement back to the minimum observed for the period 1950–2010.

Figure 9.4Difference between the Expected Duration of Retirement Projected for 2050 and Other Periods

(Years)

Source: Based on data on pensionable ages updated from OECD (2012b) and on life expectancy based on mortality estimates from UN population projections (2010 revision).

Note: Projected life expectancy at pensionable age is estimated using the mortality estimates of UN population projections (2010 revision) and pensionable age resulting from reforms that are either in place or under way.

Retirement age is probably the most visible parameter of a pension system. Reforms that aim to increase it remain very contentious and have led to social conflicts in some European countries. A Eurobarometer survey on aging and solidarity issues shows that six out of ten Europeans reject the idea that the retirement age needs to increase by 2030 (European Commission, 2012c). In contrast, in some countries, such as Denmark, Ireland, and the Netherlands, a majority of the respondents to the survey acknowledged the need for official retirement ages to increase further (OECD, 2013c).

Incentives embedded in pension systems also matter for retirement decisions (OECD, 2011c; D’Addio, Keese, and Whitehouse, 2010). Indeed, qualifying conditions and penalties for early retirement, as well as increments to benefits for late retirement, may affect the willingness of individuals to continue working. To lengthen working lives, some advanced European economies—such as Austria, Belgium, Denmark, France, Germany, Greece, Italy, Poland, Spain, and the United Kingdom—have modified these parameters.

Increasing the labor demand for older workers

Interventions on labor supply are not enough: labor demand policies are essential. Older workers need help maintaining and enhancing their human capital to make them more employable, especially around mid-career. Seniority-based wage structures, which make it expensive to employ older workers, need to be reconsidered. Strict employment protection regulations can have unintended consequences, such as less hiring of older workers and the attraction of early retirement (OECD 2011c; D’Addio, Keese, and Whitehouse, 2010).

The cohorts of older people are getting larger while those of younger people are shrinking (and younger people are striving to find stable jobs), and employers need to adapt to these changes. Public policy may help in this respect, both to fight age discrimination (which is still an issue in some countries) and, more generally, to get employers to consider older workers to be strategic human resources.

To give older workers more choices about retirement may also positively affect their willingness to continue working. Some older workers might prefer to leave the labor market gradually. Others might prefer to stop working immediately upon reaching retirement age. More part-time work and telecommuting may help older people to extend their working lives. Flexible roles and schedules, and more command over the work they do, might increase older people’s willingness to stay in the labor market. As OECD (2011a) has shown, many older people take on caring responsibilities, either for their grandchildren or for older family members. These persons may consider working full time to be an impediment to their caring responsibilities, which may lead to their withdrawal from the labor market.

Employers have an important role in making these changes happen. Besides flexibility, the offer of adequate training and learning opportunities is important to preserve and enhance workers’ skills, and may also lead to productivity gains. Career guidance also matters for older individuals. Moreover, shifting heavier tasks onto younger workers may help both to prevent accidents in the workplace and to reduce health risks for older workers. Older workers may also play a crucial role in training young workers, especially in sectors that require specific knowledge and expertise.

The role of taxation

Tax policy may also affect the retirement decision; for example, where taxes and social contributions on part-time work are too high, older people may decide to retire as soon as they reach retirement age. Taxes and benefits that do not penalize working beyond retirement age might make it easier and eventually encourage a flexible transition into retirement. For example, although combining work and pension receipts is not permitted in Luxembourg, those who continue working beyond retirement age receive refunds of the social contributions. In other countries, such as the United Kingdom, people working beyond the statutory pension age do not pay national insurance contributions.

Pension rules also play a key a role in the extent to which people want to combine or succeed in combining work and pensions. For example, working longer does not reward individuals when the system is not actuarially fair, or when pension entitlements no longer accrue after a given number of years. Also, the salary used as a reference for pensionable earnings may reduce a worker’s willingness to stay in the paid labor market beyond retirement age.4

Other Reforms

Reducing benefits

To enhance the financial sustainability of pension systems, some advanced European economies, such as Greece, have cut benefits directly. These direct cuts are very rare whereas indirect cuts are more common. Indirect cuts tend either to apply equally (or almost equally) across different earning levels—Austria, Finland, Germany, and Italy—or to preserve lower earnings—as in France, Portugal, and Sweden.

Indirect cuts to pension benefits may take various forms. One is the change in the reference salary used for pensionable earnings. Many countries moved from a limited number of best or final years’ earnings to average lifetime earnings (Austria, Finland, Italy, Poland, Portugal, the Slovak Republic, and Sweden) or to longer assessment periods (France). This move tends to make the system more progressive, whereas using a limited number of years (best or final) often rewards workers who have best or final years’ earnings higher than their lifetime average earnings. Moreover, in countries with large informal sectors, reference to a limited number of best years provides a large incentive to underreport earnings in earlier years and in other countries, they reinforce the system distortions.

Many countries have also moved toward a stronger contributory principle.5 This transition has occurred mainly through an increase in the number of years of paid (versus credited) contributions needed to qualify for a full pension and through the switch from defined benefits to defined contributions in private pension provision.

Changes have also occurred in valorization and indexation measures, with countries tending to move to less generous adjustments to reduce costs. Valorization and indexation measures generally aim to protect retirement incomes against the risk that inflation will erode earned entitlements of still-active workers on the one hand, and pension payments on the other hand. Countries valorize or index with reference to prices, wages, or a mix of the two (see OECD, 2011c). For example, changes in valorization procedures have a large impact on retirement incomes because of compound interest effects. Based on the OECD baseline assumption of 2 percent annual growth in real earnings to model pension entitlements, uprating pension entitlements earned in the past using price inflation results in a pension 40 percent lower than under a policy of earnings valorization (over a 45-year career, from age 20 to age 65).6

In many advanced European economies, the retrenchment from public pension systems has occurred through a shift toward private pension provision, the role of which is expected to grow.7 This move enhanced the diversity of retirement incomes, but it has increased the share of risks borne by individuals because the shift has occurred mainly through the move away from traditional defined-benefit schemes toward defined-contribution pension schemes in which the investment and longevity risks are transferred from the provider to the individual or household (OECD, 2012b, 2013c).8

Automatic adjustment mechanisms in pension systems

Finally, an important development in pension systems is the introduction of automatic links between demographic, economic, and financial developments and the retirement income system (D’Addio and Whitehouse, 2012; Chapter 2 in OECD, 2012b). This innovation attracts considerable interest for economic and political reasons.

Automatic adjustment mechanisms are intended to improve the credibility of the system and avoid unanticipated burdens (see Box 9.1). In theory, putting pensions on “autopilot” may immunize pension financing against most of the demographic and economic risks discussed in this chapter. It may also protect the pension system from political risks, making it easier to introduce changes to parameters and rules—changes that are often contentious.

Risks and Pensions: How to Balance Adequacy and Sustainability Objectives

The times between when people start to contribute, when they claim a pension, and when they claim their last benefit are long. Therefore, pension promises are subject to a large range of risks and uncertainties.

Box 9.1Automatic Adjustment Mechanisms in Pension Systems

As discussed in D’Addio and Whitehouse (2012) and in OECD (2012a), a variety of instruments can be used to adjust pension systems to demographic and economic changes to make them financially sustainable. Some of these are (1) adjustments in the benefit level (or the value of pension benefits), which directly reduces expenditures; (2) adjustments in pension eligibility ages, which cuts spending by reducing the duration over which pensions are paid and increases revenues through longer payment of pension contributions; (3) adjustments in contribution rates, which increase the revenues of the scheme; and (4) drawing on a reserve fund, providing one exists.

The way in which these “automatic” adjustments work may vary. For example, contribution revenues might be increased by enlarging the base (raising the ceiling, levying contributions on unearned income, and so forth) rather than by increasing the rate. Benefit levels can be cut in different ways: proportionally for all or proportionally lower cuts for low earners. Effective benefit cuts can be imposed on existing retirees by changing the policy for indexing pensions in payment. Benefit cuts on current workers can be restricted only to new pension accruals or can be applied to the rights already accrued.

The most common automatic adjustments link benefits to life expectancy. This link has been strengthened by the shift away from defined benefit to defined contribution plans in private pension provision. In the provision of public benefits, the link to life expectancy has occurred via the move to notional defined contributions (see, e.g., D’Addio and Whitehouse, 2012) or with the introduction of specific mechanisms in defined benefit plans (as in Finland, Germany, and Portugal).

Many countries are moving toward linking pension age or contribution periods to life expectancy. These mechanisms already exist in Denmark, France, Greece, and Italy.

Investment risk is only one of them; the demographic, economic, and societal developments that have occurred in the past few decades are also of paramount importance for public pension provision. The increase in life expectancy and the decline in birth rates have resulted in rapid population aging and rapidly growing costs of paying for pensions. This cost has become even more difficult to finance with the onset of the crisis because of the general decline in government revenues. The high level of public pension expenditure—projected to persist through the coming decades—has thus become a key concern, involving changes in both fiscal and labor market policy.

Since the end of World War II, pension reforms have become central to the policy agenda of many European countries, first in their construction and expansion, then in consolidation and retrenchment (see, e.g., Whitehouse and others, 2009; Clements and others, 2013; OECD, 2011c, 2012b, 2013a, 2013e). The scale of the adjustments in these reforms often requires people to change their working and saving behavior.

The key question has become, how can governments maintain retirement income adequacy while enhancing, maintaining, and restoring the financial sustainability of pension systems? In other words, how can governments design pension systems that are both socially and financially sustainable, affordable, and equitable? (OECD, 2011c, 2012b, 2013c).

This is clearly a difficult task: Adequacy may be pursued by increasing public pensions, but these increases come at a higher cost for the state, which worsens financial sustainability. Conversely, substantial reductions in public benefits come at the expense of lower social sustainability, which may lead to higher poverty risk for the elderly and thereby to higher spending on safety net benefits.

These issues clearly have no simple answers. National retirement income systems are complex, and the pension benefits they deliver depend on a wide range of factors. Differences in pension systems’ parameters and rules, but also the diversity of socioeconomic and demographic conditions of each country, add to this complexity. Moreover, an ideal pension system, a sort of one-size-fits-all, does not exist. But a number of principles that can help pension systems to cope with demographic, financial, and socioeconomic risks do exist.

With increasing life expectancy and improved health conditions, extending working lives would help achieve the twin objective of social and financial sustainability (OECD, 2011c, 2012b). By working longer, individuals can accumulate more pension entitlements to finance (possibly longer) retirement periods. Extending working lives might also improve the finances of the system by increasing its revenue base. This measure might be more acceptable than increasing contribution rates—which may be perceived as an increased tax and thus distort employment behaviors.

However, although people may start to have a more favorable view of working beyond the retirement age, the possibility of them actually doing so depends on a number of factors. National socioeconomic contexts, rules and parameters of pension systems, labor market policies, other social policies, and individuals’ characteristics and preferences are among these.

To meet the twin objectives of social and financial sustainability, countries might also improve the targeting of public pension benefits by focusing on those individuals who are most in need of this type of support. More finely tuned redistribution might help reduce poverty in old age while keeping public pension expenditures at lower levels. Better targeting is essential because retirement benefits are not equally distributed among the elderly: some older people may have satisfactory levels of income in their later years while other older people may be in poverty. Some may be “asset rich and income poor” while others may be “asset poor and income poor,” which makes a substantial difference in their standards of living (D’Addio, 2014).

A third way to help solve the current pension puzzle is to encourage people to save more, for example, by increasing coverage of, and contributions to, private pensions. A diversified pension system may also help reduce the exposure of pensioners to excessive risks (OECD, 2012b).

Conclusion

Future retirees’ public pension entitlements are likely to be very different from those of current retirees. The characteristics of pension systems will shape some of the differences. However, the extent to which people will be willing and able to work longer and to save more and the ability of the social protection system to cushion events that lead to diminished entitlements will also be crucial determinants of future pensions.

Demographic, social, and economic developments are transforming the societies of many advanced European economies and causing important risks and challenges for their public pension systems to arise. Indeed, in an environment characterized by rapid population aging, low economic growth, and rising unemployment, revenues tend to decline while expenditures tend to increase.

Therefore, achieving the twin objectives of financial sustainability and retirement income adequacy has become even more difficult than in the past but remains essential for countries to meet their pension promises.

Improved financial sustainability might be pursued together with a set of rules or principles to ensure that benefit levels remain adequate. In contrast, the achievement of financial balance through continuous cuts to pension benefits may lead to extra spending on safety nets in the future and any savings might then be offset by larger spending needs.

Retirement ages or contribution rates might increase further. However, some individuals cannot continue working at older ages while others can. These differences depend largely on individuals’ socioeconomic characteristics and may mean that the process of increasing pension ages might, at some point, reach a ceiling (Whitehouse and Zaidi, 2008; D’Addio and Queisser, 2011). Similarly, the increase in contribution rates may continue only if younger generations are willing to shoulder a growing burden of contributions and taxes. Instead of increasing contribution rates, countries might extend coverage more broadly to workers in atypical work or in self-employment. Countries might also shift part of pension financing from wage-based contributions to more general taxation, which will reduce the nonwage labor costs, though this solution may encounter resistance.

The main challenge that advanced European economies still face is how to increase the effective retirement age. Increases in pension ages alone may be insufficient to ensure that older people work longer if there are other barriers—for example, on the labor demand side—that prevent them from finding and retaining jobs (D’Addio, Keese, and Whitehouse, 2010; OECD, 2011c). In this respect, public policies have an important role to play to reduce age discrimination and to improve both training opportunities and working conditions for older workers. However, for these policies to be successful, employers have to recognize the potential and richness of the older workforce as a strategic resource to be mobilized.

Age-management strategies are becoming more common in the workplace, but there is room to develop them further. Issues of learning and qualification, of career development at older ages, of health and work, of job design, of flexible working times and retirement patterns need to be addressed to effectively change the situation of older workers. These policies might also provide productivity gains, and thereby sustain economic growth, while addressing the issue of retirement-income adequacy.

Another challenge facing pension systems is that of people who have precarious jobs and earnings profiles during their working lives. Pension systems have moved toward a strong contributory principle, which depends on a stronger link with paid employment. Even though voluntary contributions can be paid to help secure entitlement to certain benefits, the largest share of pension benefits will be related, in the future, to paid employment and to the earnings received while working.

Social and labor-market risks that affect the periods of time spent in paid employment or the level of earnings—such as being unemployed, caring for children and elderly relatives, or consistently earning low wages—may have important consequences for the adequacy of long-term pension entitlements. Mechanisms that cushion the potentially negative effects of some social and labor market risks are therefore important (OECD, 2013b, 2013e). Shorter contribution histories because of lower women’s pension ages will also lead to lower pension entitlements, even in the absence of a gender pay gap. In this respect, the equalization of pension ages between men and women is an essential step to fight against old-age poverty.

The increasing role played by private pensions may also pose specific challenges for retirement-income adequacy because, unlike public pensions, private pensions are voluntary in many countries. The concern in this case is how to ensure that people are contributing enough to secure a comfortable retirement income. Participation in and contributions to these plans largely follow from decisions made by employers and individuals, leading to wide disparities in coverage and contribution rates across the population and between countries (OECD, 2012b; Antolin and Whitehouse, 2009).

Political risk may be reduced with automatic adjustments; however, these mechanisms do not solve some important behavioral challenges, such as how to encourage people to either work longer or save more. For example, increasing the official retirement age does not ensure that people will actually work longer. Reducing public benefits does not ensure that people will save more in alternative financing vehicles. Putting pensions on autopilot might also mean that future financial sustainability is enhanced at the expense of lower social sustainability. Much more effort should therefore be devoted to correctly designing these mechanisms and to identifying the failures that may derive from their implementation.

Trust in the system has also been undermined by the financial crisis. The complexity of pension systems obviously does not help. This lack of clarity makes it difficult for the average contributor to know his or her future entitlements. Transparent changes and clear information might help improve confidence in the pension system. In this respect, financial education is important for both young and older workers to enable them to make adequate pension preparations. Young people, in particular, need to understand how and in what forms they can save. They also need to know that even though they shoulder the pension systems in many countries, they are not the only givers: older people are substantial givers of time and money (see OECD, 2011a). Acknowledging this is important for future intergenerational solidarity.

Thus, current conditions may require further efforts by both contributors and pensioners. The policy issues then become whether future workers can afford further increases and whether the revenue base can be extended such that the burden can be shared more equitably across generations.

Given the current economic context and the fragile outlook for the future, discussing financial sustainability alone is not enough. To create a more inclusive path for growth, the question of the adequacy of pension benefits—the social sustainability of pension systems—should be an essential part of the debate on future pension systems. In this perspective, getting a better understanding of the living standards of the elderly is essential, which indicates that other resources beyond retirement incomes, such as real and financial wealth and publicly provided services, should be considered (OECD, 2013e).

The design and implementation of pension systems may also require an open, clear, and constructive debate with the different stakeholders. This may also provide individuals with better opportunities to be proactive and to adapt their saving and work behaviors to changing circumstances.

In summary, pension systems are facing large socioeconomic, labor market, demographic, financial, and budgetary challenges to which there is no magic solution. A comprehensive strategy aimed at boosting labor force participation, increasing the willingness of older workers to stay in the labor market longer, and encouraging people to save more while protecting the most vulnerable is essential.

Recognizing the need for pension policies to be conceived and realized in connection with other arrangements, such as family policies, labor market policies, and education policies, is also important. Only a holistic approach to aging, together with a good-quality, well-integrated, social protection system, will help governments cope with both existing and new risks and challenges.

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In the context of slow economic growth, the evolution of average wages may also influence the effectiveness of minimum pensions because of wage indexation. For example, when the reduction in wages is larger than price increases, the median income stabilizes or declines and wage indexation may not protect pensioners from poverty risk.

Such calculations assume that the value of the poverty thresholds do not change over time so incomes of the working-age population do not increase. This, of course, is not a desired result for the economic development of the EU.

Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

See OECD (2013c) for an extensive discussion about the options used in the EU; also see Eurofound (2012).

When pensions are based on a contributory principle, entitlement to benefits is conditional on having contributed enough, either length of the contribution period, contributions paid, or both.

Governments also tend to modify indexation rules, typically in a procyclical way, which introduces a substantial degree of political risk in the purchasing power of retirement incomes (Whitehouse and others, 2009).

According to Antolin (2008), 10 out of the 30 OECD countries analyzed had mandatory occupational funded pensions, in 8 they were mandatory personal, in 26 they were voluntary occupational, and in all there were some voluntary personal schemes.

See also the OECD road map for the good design of defined-contribution schemes presented in Chapter 5 of the OECD Pensions Outlook (OECD, 2012b). See also Antolin, Payet, and Yermo (2012).

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